The Employee Benefit Research Institute (EBRI) appreciates the opportunity to submit written comments on several questions delineated by the Subcommittee about the focus of this hearing¾ namely, how personal accounts would be administered and financed, how they would be integrated with other private pension plans, and how they would work within current tax law. Our contribution addresses these issues from an employer perspective.

Traditional Social Security reforms—cutting benefits and raising taxes—have well-known implications for employers. Benefit cuts create pressure for enhancements to employment-based pensions and require plan adjustments; tax increases add to business costs and slow the growth of cash compensation. However, public opinion surveys reveal little support among a significant percentage of voters for these traditional fixes relative to adding a system of individual Social Security accounts¾ an unprecedented reform with uncertain employer consequences.

Individual Social Security accounts could affect employers in many ways. Most obviously, employers would be affected by any change in the Social Security payroll tax if they are required to match employee contributions, as under current law. Second, the effects of individual accounts on retirement decisions and employee demand for private plans could affect pension design and offerings. In addition, individual accounts would certainly influence plan design features and pension offerings of employers who have retirement plans that are integrated with Social Security (i.e., the employers of approximately 7.7 million workers in medium and large establishments). Finally, individual Social Security accounts could impose additional administrative costs and burdens on employers, depending on the extent to which individual accounts contributions would be made within the framework of current tax law. This testimony discusses each in turn and is largely based on the article, "Potential Consequences for Employers of Social Security 'Privatization': Policy Research Implications" (Risk Management and Insurance Review, 1997) (Exhibit 1), as well as the forthcoming EBRI Notes article, "Administrative Costs for Individual Social Security Accounts."

Employers as Reporters of Payroll Contributions

Recently, the National Council on Retirement Policy (NCRP) recommended that a system of individual Social Security accounts be designed to work "within the current payroll tax structure." In the current tax framework, employers send the U.S. Treasury aggregate Social Security (FICA) taxes (employee contributions plus employer matching contributions) relatively frequently, depending on employer size. However, employers must reconcile only once a year which portion of the aggregate FICA contribution has been paid on behalf of each employee (through the W-2 form). Because they have largely not addressed the issue, it is unknown whether other groups recommending individual Social Security accounts would concur with NCRP's recommendation that the current tax structure be used. Were the current tax structure maintained for individual Social Security accounts, a lapse of over one year would occur between the time when contributions are made on behalf of an employee and the time when those contributions are credited to the employee's individual account.

While options exist for having the government retrospectively credit contributions made on behalf of individuals to individual investment choices in individual accounts, such a time lapse would nonetheless stand in contrast to current 401(k) plan operation. Therefore, staying within the current tax structure may be unacceptable to those who view private 401(k) plans and minimal government responsibility as guideposts for any reform. As a result, some reformers might insist on an increased number of deposit transactions over the year. Depending on frequency, additional transaction requirements would inflate administrative expenses because of the additional work imposed on employers¾ especially smaller ones. On top of these costs, additional administrative costs for employers could arise if employers were responsible for keeping track of employees' investment choices or voluntary contribution rates. Further costs would be added if employers were required to send individual account contributions on behalf of each employee to a range of service providers available under different investment options.

B. Employers as Pension Providers

Individual Social Security accounts could affect the design of existing pension arrangements in two broad ways. First, almost one-half of workers in medium and large establishments are covered under defined benefit plans whose formula is integrated with Social Security (U.S. Department of Labor, 1995). When determining the benefit levels that an employment-based retirement plan must provide to workers of different preretirement incomes in order to replace—in combination with Social Security—a target percentage of preretirement income, integration formulas for defined benefit pension plans adjust for the fact that Social Security’s benefits provide higher replacement rates for low-income workers. In addition, an unknown number of employers offering defined contribution plans informally take Social Security benefits into account when determining benefit provisions for workers of different income groups.

Most proposals for adding individual Social Security accounts call for reducing Social Security’s defined benefit. If Social Security defined benefits are reduced, benefits levels needed from an employment-based plan using an integration formula would increase, adding to compensation costs and possibly slowing the growth of cash wages. Alternatively, the employer might not pay these costs and instead adjust the integration formula to provide smaller replacement rates to retirees. This would create an administrative expense for adjusting the formula and ensuring all government regulations for the plan as a whole are still met after the adjustment. Moreover, if employers were to try to integrate their pension plans with a Social Security system that has a defined contribution component, integration to achieve desired replacement rates could not be done as precise under Social Security's defined benefit system (because of the uncertainty of investment performance).

A second way that employment-based pension design could be affected depends on workers' confidence in the system of individual accounts. If employees expected to receive larger Social Security benefits per dollar of contribution under a reformed system than under the status quo, confidence in the Social Security system might increase. Presumably, the more confidence younger workers have in Social Security, the less pressure they will place on employers to enhance employment-based retirement plans. Under a system of individual Social Security accounts, depending on the reform features, confidence in Social Security could also result in less employee demand for employer-based defined contribution plans. For example, if highly compensated employees are able to defer their preferred level of salary without the need of a qualified 401(k) plan, employers may be less inclined to offer matching contributions to motivate nonhighly compensated employees to increase their participation/contribution rates. If that were to happen, meeting the required nondiscrimination requirements might become problematic for 401(k) plans.

On the other hand, loss of part of the defined benefit guarantee under Social Security could result in more pressure on employers to provide guaranteed benefits. Because such guarantees can be promised only through defined benefit plans, employers would likely experience additional administrative costs (Hustead, 1997) and increased exposure to market risk if they responded to such employee demand. In addition, if individual account reforms left many without enough retirement income under Social Security, employers might be called upon to make up the difference by increasing their benefits for retired workers.

C. Employers as Payroll Taxpayers

One of privatization’s primary potential advantages to employers is its potential to maintain Social Security benefits at current levels without raising employer payroll taxes or reducing benefits by leveraging higher returns from the equities markets for Social Security contributions. Assuming that the equity premium will persist, returns on Social Security funds invested in the equities market will generate additional program revenue, obviating the need for future tax increases to supplement program shortfalls. Some individual account plans (such as the 1994-96 Advisory Council's Individual Accounts Plan) would raise program revenues in this way by requiring additional contributions on the part of workers but not employers. The Individual Accounts Plan supported by Ed Gramlich and Marc Twinney, for example, mandates payroll contributions of 1.6 percent of taxable payroll from workers' wages. As described above, tax increases on employers and benefit reductions are likely to increase compensation costs, slow the growth of cash compensation, and increase pressure for enhancements to employment-based retirement plans. Insofar as Social Security privatization can avert tax hikes and benefit reductions, it will benefit employers.

D. Employers as Employers of Older Workers

Under certain designs, a privatized system of individual accounts could make it more difficult for employers to retire older workers. For example, if employees near retirement age have a large enough amount of their retirement security tied to the equities market through an employment-based plan as well as through Social Security, then a downturn in the market might delay retirement. Alternatively, since individual accounts allow workers to reap direct benefits from account contributions under favorable investment performance, older workers might respond to this incentive by remaining in the labor force longer. The influence of market returns on retirement decisions could make the retirement patterns on which employers base their pension and salary scales unpredictable. In addition, older workers’ decision to remain employed during a market downturn would occur just when employers might most need to downsize their work force, particularly their higher paid employees, in order to cut costs. While these retirement issues already exist for employers with defined contributions plans, individual Social Security accounts could exacerbate these concerns by linking an increasing portion of retirement security to market performance.

Conclusion

In summary, employers potentially have much to gain or lose under a system of individual Social Security accounts, depending on reform details. Important details include how the individual account reform would handle taxation and administration, as well as the extent to which the reform would increase employees' reliance on market performance for retirement security and affect employee demand for employment-based pension offerings. Most obviously, employers would be affected by any change in the Social Security payroll tax if they are required to match employee contributions. Plus, the effects of a system of individual accounts on retirement decisions and employee demand for private plans could affect pension design and offerings. In addition, individual accounts would certainly influence plan design features and pension offerings of employers whose retirement plans are integrated with Social Security (i.e., the employers of approximately 7.7 million workers in medium and large establishments). Finally, individual Social Security accounts could impose additional administrative costs and burdens on employers, depending on the extent to which individual accounts contributions would be made within the framework current tax law.

References

Advisory Council on Social Security (1997) Report of the 1994–1996 Advisory Council onSocial Security. Vols. 1 and 2. Washington, DC: Advisory Council on Social Security.